What Actually Happens During a Bank Run?

Few events in finance are as dramatic, or as misunderstood, as a bank run. To the average person, it can seem irrational. Why would thousands of customers suddenly rush to withdraw their money from a bank that appeared perfectly healthy only days earlier? Yet throughout financial history, bank runs have repeatedly demonstrated that confidence is one of the most valuable assets a bank possesses. In fact, a bank can fail not only because of bad loans or poor management, but also because depositors lose faith in its ability to meet future obligations.

The collapses of Silicon Valley Bank in 2023, Washington Mutual during the Global Financial Crisis, and hundreds of banks during the Great Depression all illustrate the same fundamental principle. Banking is built on trust. When that trust disappears, even a financially sound institution can find itself under severe pressure.

To understand why bank runs occur, it is important to first understand how banks operate. Contrary to popular belief, banks do not keep all deposited money sitting in vaults waiting for customers to withdraw it. Instead, they employ a business model known as maturity transformation. Banks accept short-term liabilities in the form of customer deposits, while investing those funds into longer-term assets such as residential mortgages, business loans, commercial property lending, and government securities.

Consider a simplified example. Imagine a bank has $1 billion in total assets. Of this amount, $700 million may be tied up in home loans, $200 million in business loans, $80 million in government bonds, and only $20 million held as cash reserves. On the funding side of the balance sheet, the bank may have $900 million of customer deposits and $100 million of shareholder equity. Although the institution appears financially healthy, only a small proportion of its assets are immediately available as cash. The remainder are productive assets that generate income but cannot be converted into cash instantly without potentially incurring losses.

Under normal circumstances, this structure functions efficiently because not all depositors withdraw their money at the same time. Banks rely on historical patterns of customer behaviour, which show that only a small percentage of depositors require access to their funds on any given day. This allows banks to lend out the majority of deposited funds while still maintaining sufficient liquidity for routine withdrawals.

Problems arise when confidence begins to deteriorate. Imagine rumours emerge suggesting that a bank may be experiencing financial difficulties. Even if those concerns are exaggerated or unfounded, depositors are forced to make a decision. If they leave their money in the bank and the institution remains stable, they lose nothing. However, if the bank does fail and other customers withdraw their funds first, they may face delays, restrictions, or losses. As a result, withdrawing funds becomes a rational action even for individuals who do not fully believe the bank is in danger.

This creates what economists describe as a self-fulfilling prophecy. Depositors withdraw money because they fear the bank may fail. The withdrawals reduce the bank’s liquidity position. The declining liquidity creates genuine financial stress. That stress then validates the concerns that triggered the withdrawals in the first place. As more customers observe others withdrawing funds, panic can spread rapidly throughout the depositor base. A critical distinction in banking is the difference between liquidity and solvency. A solvent bank is one whose assets exceed its liabilities. A liquid bank is one that has sufficient cash available to meet immediate obligations. Bank runs often begin as liquidity crises rather than solvency crises.

Suppose customers suddenly demand $200 million of withdrawals from the hypothetical bank described earlier. The bank only holds $20 million in cash reserves. To satisfy depositor demands, management must quickly raise an additional $180 million. This often requires selling securities or loan portfolios into the market. Unfortunately, assets sold under pressure rarely achieve their full value. Government bonds with a book value of $80 million may only fetch $74 million in a distressed sale. A loan portfolio recorded at $200 million may attract buyers willing to pay only $170 million. These losses directly reduce shareholder equity and weaken the bank’s financial position.

At this stage, what began as a liquidity problem can evolve into a solvency problem. Forced asset sales reduce capital levels, increasing concerns among depositors, investors, and regulators. This phenomenon is known as a fire-sale spiral. The more assets the bank is forced to sell, the greater the losses it incurs, and the greater the pressure on its balance sheet.

The collapse of Silicon Valley Bank in March 2023 provides a modern example of these dynamics. During the period of exceptionally low interest rates between 2020 and 2021, the bank invested a significant proportion of customer deposits into long-dated United States Treasury bonds and mortgage-backed securities. When central banks aggressively increased interest rates during 2022 and 2023, the market value of these securities declined substantially. While the losses were initially unrealised, concerns emerged regarding the bank’s financial strength and ability to raise capital.

Once several prominent venture capital firms advised their portfolio companies to withdraw funds, confidence deteriorated rapidly. Depositors attempted to withdraw approximately US$42 billion in a single day, representing nearly a quarter of the bank’s total deposits. No bank is designed to withstand withdrawals of that magnitude over such a short period. The institution quickly exhausted available liquidity and ultimately failed, becoming one of the largest bank collapses in American history.

Governments and regulators recognise that confidence-driven runs can threaten even fundamentally healthy institutions. This is one of the primary reasons deposit insurance schemes were established. Deposit insurance changes depositor incentives by assuring customers that their funds are protected up to specified limits. When depositors believe their money is safe regardless of what happens to the bank, they have less reason to participate in a panic-driven withdrawal.

Central banks provide an additional layer of protection through their role as lenders of last resort. Banks facing temporary liquidity shortages can borrow against high-quality assets, allowing them to meet withdrawal demands without resorting to distressed asset sales. This mechanism helps prevent liquidity problems from escalating into broader solvency crises.

Ultimately, banks do not simply manage money, they manage confidence. Unlike most businesses, a bank’s liabilities can often be demanded immediately, while its assets may take years to mature. This mismatch creates an inherent vulnerability that can only be managed through adequate liquidity, strong capital positions, effective regulation, and public trust. A bank run therefore represents more than a financial event. It is a collective loss of confidence that transforms fear into reality. In banking, perception can influence behaviour, behaviour can influence liquidity, and liquidity can determine survival. That is why fear alone, if widespread enough, can be sufficient to bring down an entire bank.